P2P Lending: Can Diversification Reduce Risk For Lender?

Peer-to-peer (P2P) lending has come as an alternative investment option for investors who are looking for returns outside traditional fixed income products. But, like any other form of lending, P2P lending carries credit risk - the risk that a borrower will delay repayment or default on the loan.

A very common way to deal with this risk is to diversify. But does diversification in P2P lending really reduce risk? The answer is yes, but it has to be done thoughtfully.

Diversification arises when you spread your lending out to many borrowers instead of lending a large sum to one borrower. The basic idea is simple: a lender should not have to depend on a single borrower to determine the performance of his lending portfolio.

Says Mohan Parsuramka, COO and head – P2P Business at 1 Finance: “Say, for instance, a lender wants to lend Rs 1 lakh. If the entire amount is lent out to one borrower and that borrower defaults, then a large chunk of the portfolio could get hit. On the other hand, if the amount is divided evenly among, say, 50 people borrowing Rs 2,000 each, then the failure of just one borrower will affect only a small percentage of the entire portfolio.”

Therefore, diversification helps in reducing concentration risk. But it is not necessarily the case that the portfolio is well-diversified simply because it has a large number of loans.

Even if all borrowers have similar financial characteristics, are engaged in the same industry, are located in the same area or belong to the same risk category, the portfolio may still be exposed to common risks.

For instance, a lender might lend to 100+ borrowers, but if most of them are in the same sector, an economic downturn could hit many borrowers at the same time.

“Thus, for diversification to work, it must be more than just the number of borrowers. Lenders should consider diversification of their portfolio by borrower type, credit grade, income level, employer, industry, geographic location and loan tenure,” says Parsuramka.

Another important factor to account for is that diversifying across many borrowers on one P2P platform does not eliminate the risk of the single platform. A lender might have exposure to hundreds of borrowers, but if the loans are all originated and managed by the same platform, the portfolio is still dependent on the platform’s processes and capabilities in holistic underwriting and other critical processes, such as collection and recovery. Some examples include poor underwriting standards, poor assessment of the borrowers, no control over frauds, and inefficient collections. These shortcomings can impact a large number of loans at the same time.

“Poor underwriting can lead to the acceptance of riskier borrowers, and poor collections may reduce the probability of recovering late payments. Therefore, borrower-level diversification cannot fully protect the platform-level credit assessment, operations or collection framework,” says Parsuramka.

Diversification can help smooth the portfolio’s performance, but delayed payments or defaults of some borrowers will be balanced by the timely repayments of some other borrowers. However, it cannot eliminate credit risk, guarantee repayment, or prevent losses in a broad economic downturn. Also, it cannot substitute for bad borrower assessment or bad platform practices. Therefore, diversification must be in line with due diligence.

“Lenders should check borrowers’ credit history, existing obligations, repayment capacity and overall risk profile, as well as the stability of their income. They should also look at the platform’s underwriting methodology, borrower selection criteria, collection capabilities, disclosures, governance and operational processes,” says Parsuramka.

Lenders should not be looking for the highest interest rates on offer. Higher returns usually mean higher risk. They should instead build a diversified portfolio based on the lender’s risk tolerance, lending horizon and liquidity requirements.

To conclude, diversification is an excellent way of dealing with the concentration risk in P2P loans. However, diversification of borrowers does not mean risk elimination. It can reduce the risks from an individual default, but it cannot eliminate the risk of default or the risk of a single platform.

“A responsible P2P lending involves a disciplined approach, which includes diversification of borrowers, selection of platform, exposure limits, proper underwriting, and periodic monitoring of the portfolio,” says Parsuramka.